Supranational supervision: How much and for whom?

Thorsten Beck, Wolf Wagner 20 July 2013

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The question of how to regulate and supervise banks across countries has taken the centre stage in the debate on the reform of the banking sector. The failure of internationally active financial institutions, such as Lehman Brothers, and cross-border banks, such as Fortis, Dexia or the Icelandic banks, played a prominent role during the Global Crisis. As a consequence, there is a growing recognition that Memorandums of Understanding and Supervisory Colleges are not sufficient to deal with large and systemically important cross-border financial institutions. Closer cooperation between supervisors especially in the resolution phases has been advocated, with currency unions such as the Eurozone even considering the setup of a banking union.

A small but growing literature has analysed cross-border cooperation on capital and liquidity requirements (Dell’Arricia and Marquez 2006, Loranth and Morrison 2007), with only a few papers focusing on the resolution stage (Calzolari and Loranth 2011, Beck et al. 2013). In a recent paper, we offer a simple theoretical model that can serve as conceptual framework to gauge the optimality and feasibility of cross-border cooperation in bank supervision (Beck and Wagner 2013).

A one-size-fits-all approach is not warranted

Our main hypothesis is that a one-size-fits-all approach is neither desirable nor realistic, as benefits and costs from moving towards supranational solutions differ greatly across different regions. Instead, we propose that the extent to which the regulatory architecture becomes supranational should be determined at the regional level, and sometimes even be country- or institution-specific. In particular, it should be set according to two factors:

  • The strength of cross-border externalities from financial instability.
  • The extent of heterogeneity across the countries in question.

Cross-border externalities

Externalities from bank failures partly materialise at the domestic level, for example, by causing a credit crunch in the domestic economy. Such externalities do not create a rationale for international regulation since a domestic supervisor will be best equipped to deal with them. However, the failure of banks in a country also causes substantial externalities for other countries – and increasingly so, due to the fact that the financial systems of countries have become more interconnected in recent decades, along several dimensions.

  • Externalities arise from cross-border activities of specific financial institutions, mostly through activities of cross-border branches and subsidiaries.
  • A shock arising from failure of one bank can spill to other countries through market channels such as fire-sale externalities and common asset exposures, informational contagion among investors, direct interbank exposures or counterparty risk.
  • Specific externalities arise within a monetary union because relying on a common lender of last resort might result in a tragedy-of-commons problem, as it is in the interest of every member government with fragile banks to 'share the burden' with the other members, a common theme during the current Eurozone crisis

Heterogeneity across countries

If all countries were identical, it would be easy to agree on the right structure for international regulation and implementation would be straightforward. However, countries differ in practice along various dimensions, which increases the cost of closer cooperation and convergence.

  • Countries differ in their legal systems, which makes it hard to specify a common set of rules and standards, forcing cumbersome adaptation of general principles to local circumstances.
  • Heterogeneity can arise from a different reliance of economies on banks and from differences in market structures. This influences the cost of bank failures but also the ease with which banks can be resolved.
  • Heterogeneity can arise from differences in preferences. Countries may differ for example in how they view the role of the government in the economy (one consequence being differences in state ownership), focus on fiscal independence or with respect to their risk tolerance.

The key trade-off

In Beck and Wagner (2013), we present a simple theoretical model of a trade-off between externalities and heterogeneity, which guides the optimality of domestic vis-à-vis supranational supervision of banks. The model predicts that a domestic supervisor will have a tendency to be too lenient when intervening in domestic banks due to the presence of cross-border activities. This provides a rationale for a supranational regulator, who can internalise cross-border externalities. However, supranational regulation itself can also be a source of inefficiency when the costs of intervention or bank failures vary across countries. Specifically, a supranational regulator will be too lenient for a country with high insolvency and too harsh for a country with low insolvency costs. Taken together, the model shows that the gains from supranational regulation are increasing in the extent of cross-border externalities, but decreasing in country heterogeneity.

The political economy of supranational regulation

Even when supranational regulation is desirable from a cross-country perspective, individual countries’ incentives of moving from domestic to supranational supervision can vary significantly. This explains why the move to supranational regulation often falls prey to political obstacles. For instance, countries may be of different size, which may result in a supranational supervisor adopting to a greater extent the preferences of the larger country. This may reduce – or even eliminate – the incentives for smaller countries to join.

Similarly, a country with an international financial centre might object to supranational supervision as this is likely to result in an outcome that forces the country to internalise a larger part of the externalities posed by its banking system.

The best of both worlds?

National and supranational supervision are two extreme solutions on a continuum of possible forms of cooperation on cross-border banking. One can think of intermediate solutions, such as, for example, countries agreeing on a minimum intervention threshold. This approach allows for partial internalisation of the externalities, but also permits a tailoring of intervention policies to domestic heterogeneity. The approach dominates the domestic solution – but when externalities are high it may still be less desirable than a supranational approach.

Implications for policy

Our framework provides guidance for the complex discussion on the optimality of cross-border regulatory cooperation across different groups of countries and across regions. Figure 1 shows how different combinations of externalities and heterogeneity warrant different approaches. Increased cooperation is most necessary in presence of high externalities, but might not always be possible. Take the example of financially well integrated regions that are nevertheless relatively heterogeneous, such as the US and Europe. In such a situation, moving supervision completely to the supranational level is too costly and politically infeasible. Our model suggests this would not be welfare improving, both on the aggregate level but also most likely not for individual countries.

Figure 1. Dependence of optimal supranational supervision on externalities and country heterogeneity

Our model also re-emphasises the case for a banking union for the Eurozone, given the very high externalities of bank failure across countries, while it also underlines the possible political-economy obstacles that can prevent the adoption of such a framework, given asymmetries in gains and losses from such a decision. Finally, our framework can also explain why the Baltic countries have progressed more than other regions in cross-border regulation, given high externalities, but low heterogeneity and relatively symmetric interests.

References

Beck, T, R Todorov and W Wagner (2013), "Bank Supervision Going Global? A Cost-Benefit Analysis", Economic Policy, Volume 28, Issue 73, pages 5--44.

Beck, T and W Wagner (2013), "Supranational Regulation - How Much and for Whom?", CEPR Discussion Paper 9546, July.

Calzolari, G and G Loranth (2011), Regulation of multinational banks: A theoretical inquiry, Journal of Financial Intermediation 20, 178-98.

Dell'Ariccia, G and R Marquez (2006): Competition Among Regulators and Credit Market Integration, Journal of Financial Economics 79, 401-30.

Loranth, G and A Morrison (2007), Deposit Insurance, Capital Regulations and Financial Contagion in Multinational Banks, Journal of Business Finance & Accounting 34, 917-49.

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Topics:  International finance

Tags:  banks, supranational regulation, regulatory cooperation

Thorsten Beck

Professor of Banking and Finance, Cass Business School; Professor of Economics, Tilburg University; Research Fellow, CEPR

Wolf Wagner

Professor of Economics, University of Tilburg